Cato White Papers and Miscellaneous Reports

Tax Cuts and Balanced Budgets: Lessons from the States

September 17, 1996

Stephen Moore and Dean Stansel

Stephen Moore is director of fiscal policy studies and Dean
Stansel a fiscal policy analyst at the Cato Institute

Introduction

The advisability of Bob Dole's 15 percent across-the-board
federal income tax cut has been challenged in two ways.
First, the White House and other skeptics have argued that
the tax cut will preclude balancing the budget, and will even
make the budget deficit worse. Second, many Washington
economists question whether tax cuts will stimulate the
economy or produce higher incomes, as supply-side advocates
predict.

The states, in their roles as laboratories of democracy, may shed some light
on the controversy. During the recession of 1990-91, more
than half of the states raised taxes. But in the last two
years, 26 states have enacted substantial tax cuts. In fact,
the 1995-96 biennium has been the largest tax-cutting period
for states since the early 1980s. The state tax reduction
experience is of special relevance to the current debate in
Washington, because many states have reduced income tax rates
across the board--as Bob Dole's plan proposes. The top 10
tax-cutting states reduced state taxes as a share of total
tax collections by about 6 to 7 percent. Michigan cut tax
revenues by more than 10 percent. The Dole plan would reduce
total federal revenues by 5.2 percent on a static basis and
by 4.1 percent on a dynamic basis (i.e., adjusting for higher
economic growth from the tax cut).

Tax-raising States vs. Tax-cutting States

In this study we contrast the economic and fiscal performance of the top 10
tax-raising states in the 1990s with that of the top 10
tax-cutting states. (We exclude Alaska from the study because
of peculiarities in its revenue sources.) Major findings, as
summarized in Table 1, include the following:

Budget Reserves: The budget reserves of the tax-cutting states
(7.1 percent of state expenditures) were much higher than of
the states that had raised taxes (1.7 percent) (see Figure 1). That is, tax-cutting
states are in better fiscal health this year than
tax-increasing states.

Bond Ratings: If tax cuts contribute to fiscal deterioration,
then the bond ratings of the 10 states that cut taxes the
most in the 1990s should be worse than those of the 10 states
that raised taxes. Just the opposite is true. In the
tax-cutting states, the average Moody's bond rating in 1995
was between Aaa and Aa. In the tax-raising states, the
average Moody's bond rating was between Aa and A1.

Population Growth: Americans voted with their feet in favor of
tax-cutting states. Figure 2 shows that population
gains were 4.2 percent in the tax-raising states but 7.4
percent in tax-cutting states. The tax-cutting states gained
500,000 more people than the tax increasers.

Employment Growth: Businesses and jobs migrated to low-tax states in
the 1990s. From 1990 to 1995 the United States gained 7
million net new jobs. But in the 10 states that raised taxes,
total employment did not rise at all--and in fact, it fell
slightly. The biggest job losses were in the tax-raising
states of Rhode Island, Connecticut, California, and
Massachusetts. Figure 3 shows that job growth
averaged 0.0 percent in the tax-increasing states and 10.8
percent in the tax-cutting states. None of the tax-cutting
states lost jobs.

Unemployment Rate: The superior job creation performance of the
tax-cutting states is also revealed in the unemployment data.
Figure 4 shows that the
unemployment rate at the end of 1995 was 4.7 percent on
average in the 10 tax-cutting states and 6.0 percent in the
10 tax-raising states. The unemployment rate fell in the
1990s by 0.5 percentage points in the tax-cutting states but
by only 0.2 percentage points in the tax-raising states.

Incomes:
Total state income grew by 32.6 percent in the tax-cutting
states and by 27.0 percent in the tax-raising states (see Figure 5). Per capita income
grew 21.8 percent in the tax-raising states, slightly below
the 23.4 percent average in the tax-cutting states. That
translated into a $400 greater increase in per capita income
in the tax-cutting than in the tax- raising states.

Critics of state tax cuts contend that lower state taxes mean higher
local tax burdens, thus leaving taxpayers no better off. That
claim is most prominently made about the tax cuts enacted by
Gov. Christine Todd Whitman in New Jersey. A recent study by
the Manhattan Institute concluded that local property tax
increases replaced less than one-third of the income tax cuts
signed into law by Governor Whitman. Also, many states,
including Arizona and Michigan, have coupled state tax cuts
with restrictions on the ability of local governments to
raise taxes in response.

State Economic Performance before and after Tax Cuts

We also examined the recent experience of 10 states that we think are
illustrative of the impact of tax cuts on state economic
development. They are states that had raised taxes in the
late 1980s or early 1990s, then cut them in more recent
years. We therefore examine those states' economic
performance before and after the tax cuts. The 10 states
analyzed are Arizona, California, Connecticut, Georgia,
Massachusetts, Michigan, New Jersey, New York, North
Carolina, and Pennsylvania. In 8 of the 10 states, job growth
had been negative or zero in the years before the tax cuts.
Economic growth has been positive in the years after the tax
cuts, as shown in Table 2. Here are the summaries of the
fiscal and economic circumstances in each of those states:

Arizona:
Under Gov. Fife Symington, taxes have been cut by $1.5
billion since 1992. The top income tax rate has fallen from
8.7 to 5.6 percent, and the corporate income tax has been cut
as well. Over that time period job creation, population, and
new business creation have grown at three times the national
average. Employment had actually fallen in Arizona in the two
years before Symington's tax cutting.

California:
No state has turned around its fortunes as dramatically as
California in recent years. In 1990 the legislature and Gov.
Pete Wilson enacted a $7 billion tax increase, the largest in
the history of the 50 states. The income tax hikes were
noteworthy in that they failed to raise any new revenue while
sinking the state deeper into recession as upper income
families and entrepreneurs moved out. The already ailing
economy continued to decline. From 1990 to 1993 the state
lost 350,000 jobs. In 1995 the tax hikes were repealed. Since
then California has gained 150,000 jobs and the unemployment
rate has fallen sharply.

Connecticut:
In 1991 Connecticut became the 41st state to adopt a personal
income tax. That was also the largest tax increase in
Connecticut history. It has caused an exodus from the state.
Connecticut is one of only two states to lose population in
the 1990s. In 1995 Gov. John Rowland enacted a $200 million
income tax cut, paid for by a zero growth budget after
inflation. He has cut the general assistance welfare budget,
public housing aid, and transportation funds and imposed a
hiring freeze. The tax cuts have helped pull the Connecticut
economy out of the depths of the early 1990s recession that
devastated the state's insurance, defense, and banking
industries--a recession exacerbated by Gov. Lowell Weicker's
tax grab. From 1990 to 1995, 125,000 jobs were lost. Since
July 1995, one-third of those lost jobs have been replaced.

Georgia:
In recent years, Georgia, under Gov. Zell Miller has enacted
a series of tax cuts. In 1996 Miller signed a $500 million
tax cut, exempting food from the sales tax. In 1994 Miller
approved a $100 million tax cut for families with children by
raising the dependent exemption from $1,500 to $2,500 and an
income tax cut for senior citizens with retirement income.
This tax-cutting state is booming economically. In the 1990s
Georgia has by many measures enjoyed the fastest growth rate
of any state east of the Mississippi. Employment has grown
more than twice the regional average since 1990.

Massachusetts:
Gov. Michael Dukakis's last budget contained a series of tax
increases designed to close a $1-billion-plus budget deficit.
The budget deficit was closed in William Weld's first two
years as governor through tight spending restraint,
privatization of state services, and a reduction in the
public payroll. In 1991 Weld enacted an income tax
rollback--the first of eight tax cuts he pushed through in
his first term. He also canceled several Dukakis tax hikes.
Since then, the state has regained all of the 150,000 jobs
lost during the 1990-91 recession--and the budget is running
a surplus now.

Michigan:
Gov. John Engler inherited a $1.5 billion deficit in 1991 and
quickly closed the gap through an impressive budget-cutting
agenda. He ended a general assistance program for 75,000
employable adults, slashed 6,000 workers from state payrolls,
ended low-priority programs such as funding for the arts, and
privatized homeless services and other state activities. In
1991 Engler enacted the first of 15 tax cuts. The largest and
most controversial was a school financing/tax restructuring
program under which local property taxes were sharply reduced
and the state sales tax was raised by 2 percentage points.
The plan provided a net tax cut of more than $500 million a
year. The economy is now surging in Michigan, and the
unemployment rate is lower than at any time since the
mid-1960s and well below the national average at 4.5 percent.
In the two years before Engler's tax cutting, the state had
no net new jobs. Since then, Michigan businesses have created
450,000 net new jobs.

New
Jersey: Last year Gov. Christine Todd Whitman made
good on the final portion of the 30 percent income tax cut
she promised in the campaign of 1993. The top income tax rate
in New Jersey has now been chopped from 7 to 6.37 percent--a
$1.2 billion tax cut. The typical middle-income family will
now pay about $300 less per year in state income tax.
Whitman's tax cuts were a reversal of the soak-the-rich tax
hikes enacted by her predecessor Jim Florio. As of July 1996,
80 percent of the jobs lost during the Florio years had been
recovered under Whitman. Personal income in the state grew by
nearly 4 percent last year after virtually no growth in the
Florio years.

New York:
In 1994 George Pataki narrowly defeated the nation's most
articulate champion of big-government liberalism, Mario
Cuomo, by running on a platform of Whitman-style income tax
cuts. Last year, the 20 percent income tax cut under Pataki
was as large ($2.5 billion) as those enacted by all of the
rest of the states combined. Pataki also overhauled the
state's antiquated workmen's compensation system, which now
costs New York businesses 30 percent more than the national
average. After losing one-half million jobs because of the
tax from 1990 to 1995, New York actually enjoyed an increase
of 90,000 jobs over the past 12 months.

North
Carolina: In the early 1990s North Carolina went on a
state spending binge. In 1992 total state expenditures
exploded from $16.9 billion to $19.0 billion--an enormous
12.5 percent increase. Gov. Jim Hunt pushed for more funding
for schools, day care, apprenticeship programs, and health
insurance coverage. Activist government was the guiding
principle of the day in Raleigh. And the economy grew slowly.
Since 1995 the spending spree has ended and the budget has
grown only slightly faster than inflation. In 1995 Hunt, a
Democrat, pushed through a $400 million tax cut that included
an income tax cut and elimination of the state intangibles
tax. Job growth has more than doubled since the tax cuts, and
the state economy is flourishing.

Pennsylvania:
Gov. Robert Casey enacted a $2 billion major income tax
increase--raising the rate from 2.1 to 2.8 percent--during
the 1990-91 recession. From 1990 to 1995 there was virtually
no net job creation in Pennsylvania. In his first year in
office, 1995, Gov. Tom Ridge pushed through a $200 million
business income tax cut and a workmen's compensation reform
measure that is expected to reduce premiums by as much as 10
percent. In 1996 he endorsed a reduction in the franchise tax
and a $1,000 tax credit for new hires. He has also been
tight-fisted on spending. His 1996 budget allowed spending to
grow by just 0.6 percent. In 1997, for the first time in a
quarter century, the general fund budget spends less than the
year before. That combination of tax cuts and budget
restraints has helped lead to a net gain of 100,000 jobs so
far in 1996.

Lessons for Washington

These
results--suggesting that tax cuts and spending restraint
contribute to state economic competitiveness--are consistent
with those of earlier studies. For example, in 1993 the Joint
Economic Committee compared the job creation performance and
per capita growth of incomes in the states that raised taxes
over the period 1990-93 with those of the states that cut
taxes or avoided raising taxes. The JEC found that
tax-avoiding states created 653,000 new jobs over the period
versus just 3,000 in the tax-increasing states. Yet the
tax-increasing states have much larger populations.

The experience
of the states in recent years supports the theory that when a
state raises its taxes, that raises the cost to businesses of
producing goods and services within the state relative to the
tax climate in other states. Similarly, higher taxes may
reduce the take-home pay of workers or raise the cost of
living in the state--both of those effects give workers an
incentive to migrate to other states where taxes are less
burdensome.

The state
experience should be seen as evidence of the potential impact
of an across-the-board federal income tax cut. There is
little question that states that have cut taxes in the 1990s
have improved their economic competitiveness--particularly
compared to tax-increasing neighbors. The evidence is most
persuasive in the northeastern states of Connecticut,
Massachusetts, New Hampshire, New Jersey, New York, and
Pennsylvania, where pro-growth governors have helped turn
around their states' dismal performance in the early 1990s
through income tax reductions and expenditure control.

Table 1
Taxes and State Economic Performance in the 1990s

1990-95 Growth in:

Total FY90-96 Rev. Increases as % of
1990 Pers. Inc.

Population

Employment

Unemployment Rate (% pts.)

1995 Unemployment Rate

Per Capita Personal Income

Total State Income

1.

Rhode
Island

2.401%

-1.5%

-6.7%

0.2

7.0%

22.5%

2.

West
Virginia

2.340%

2.0%

4.5%

-0.5

7.9%

28.3%

30.8%

3.

Connecticut

2.043%

-0.4%

-7.1%

0.3

5.5%

19.2%

18.7%

4.

Vermont

1.720%

3.5%

5.8%

-0.8

4.2%

20.0%

24.2%

5.

Maine

1.688%

0.8%

0.6%

0.5

5.7%

20.5%

21.4%

6.

Montana

1.517%

8.8%

8.7%

-0.1

5.9%

25.4%

36.3%

7.

California

1.425%

5.6%

-0.8%

2.0

7.8%

14.7%

21.2%

8.

Kentucky

1.214%

4.5%

5.9%

-0.5

5.4%

26.2%

31.9%

9.

Massachusetts

1.165%

0.9%

-1.2%

-0.6

5.4%

21.3%

22.4%

10.

Arkansas

1.095%

5.5%

11.0%

-2.1

4.9%

26.4%

33.4%

Tax Hikers Avg.

1.661%

4.2%

0.0%

-0.2

6.0%

21.8%

27.0%

Top 10 Tax-Cutting States, FY90-96

1990-95 Growth in

Total FY90-96 Rev. Increases as % of
1990 Pers. Inc.

Population

Employment

Unemployment Rate (% pts.)

1995 Unemployment Rate

Per Capita Personal Income

Total State Income

1.

Hawaii

-0.845%

6.6%

2.3%

3.0

5.9%

18.3%

26.2%

2.

Michigan

-0.760%

2.6%

5.8%

-2.3

5.3%

29.1%

32.4%

3.

Oregon

-0.690%

9.9%

11.6%

-0.8

4.8%

26.4%

38.9%

4.

Utah

-0.418%

12.8%

19.9%

-0.7

3.6%

29.6%

37.7%

5.

Idaho

-0.137%

14.9%

22.0%

-0.5

5.4%

25.9%

44.7%

6.

Wisconsin

-0.105%

4.5%

11.1%

-0.7

3.7%

25.5%

31.2%

7.

Arizona

0.000%

14.7%

18.3%

-0.4

5.1%

25.6%

43.9%

8.

Virginia

0.001%

6.5%

7.7%

0.2

4.5%

20.8%

28.6%

9.

New
Hampshire

0.122%

3.2%

2.6%

-1.7

4.0%

24.3%

28.4%

10.

Colorado

0.124%

13.4%

19.5%

-0.8

4.2%

24.6%

35.2%

Tax Cutters Avg.

-0.271%

7.4%

10.8%

-0.5

4.7%

23.4%

32.6%

U.S.
Average

0.641%

5.4%

5.9%

0.1

5.6%

22.1%

28.6%

Note: Alaska was excluded from the
tax-increasing group because of peculiarities in its tax code
that make interstate comparisons problematic.
Source: Cato Institute calculations, based on National
Association of State Budget Officers, Fiscal Survey of the
States, various editions, and data from U.S. Bureau of the Census
and U.S. Bureau of Labor Statistics.

Table
2

Number of Residents Employed, by
State, 1990-July 1996

State

1990

1991

1992

1993

1994

1995

Jul-95

Jul-96

1990-95

July95-July96

California

14,319,192

14,004,151

13,973,904

13,918,275

14,132,936

14,205,866

14,201,400

14,352,700

-0.16%

1.07%

Connecticut

1,738,695

1,716,245

1,680,758

1,672,617

1,639,260

1,614,931

1,611,900

1,650,000

-1.47%

2.36%

New
York

8,375,118

8,095,673

7,911,253

7,973,256

7,980,520

7,955,265

7,946,000

8,035,900

-1.02%

1.13%

North
Carolina

3,323,957

3,307,735

3,334,507

3,380,985

3,432,810

3,478,588

3,477,900

3,561,700

0.91%

2.41%

Pennsylvania

5,475,923

5,418,971

5,439,531

5,470,346

5,465,286

5,495,124

5,497,900

5,597,900

0.07%

1.82%

U.S.
Total

117,914,000

116,877,000

117,598,000

119,306,000

123,060,000

124,900,000

124,832,500

127,111,800

1.16%

1.83%

State

1990

1991

1992

1993

1994

1995

Jul-95

Jul-96

1990-94

1994-July96

New
Jersey

3,860,673

3,770,249

3,690,214

3,690,762

3,739,434

3,803,126

3,805,700

3,837,100

-0.79%

1.30%

U.S.
Total

117,914,000

116,877,000

117,598,000

119,306,000

123,060,000

124,900,000

124,832,500

127,111,800

1.07%

1.63%

State

1990

1991

1992

1993

1994

1995

Jul-95

Jul-96

1990-92

1992-July96

Arizona

1,701,079

1,668,823

1,673,329

1,715,112

1,857,454

2,012,498

2,025,800

2,036,200

-0.82%

5.03%

Massachusetts

3,032,863

2,875,527

2,875,809

2,945,402

2,976,710

2,997,569

2,997,400

3,033,100

-2.62%

1.34%

Michigan

4,246,205

4,151,912

4,245,010

4,373,777

4,480,353

4,490,922

4,474,000

4,616,700

-0.01%

2.12%

U.S.
Total

117,914,000

116,877,000

117,598,000

119,306,000

123,060,000

124,900,000

124,832,500

127,111,800

-0.13%

1.96%

Source: Cato Institute calculations,
based on data from the U.S. Bureau of Labor Statistics.